The world s delivery system for consumer goods, components, and commodities is overloaded.

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1 From Mercer Management Journal 19 Delivery Jam How will the world s freight networks cope with surging demand? By Mark Kadar and Manny Hontoria Shipping ports, trains, and trucks are running flat out to deliver components and finished products. The supply system may soon start to reach its structural limit of capacity and require further rounds of infrastructure investment. To accommodate the next two decades of growth, shipping companies, transport providers, and governments will have to collaborate to a greater extent than in the past. The world s delivery system for consumer goods, components, and commodities is overloaded. Shipping lines, ports, railroads, and trucking firms are running flat out, and there are strong indications that supply chains, particularly in North America although increasingly in other regions as well, have seen a resulting reduction in reliability and increase in cost. Trade volumes have grown largely because of surging demand caused by the strengthening economies of many countries, rapid globalization, reductions in tariffs and quotas, and increased sourcing to lower-cost centers, particularly China. At the same time, supply chains have become significantly more dependent on the reliability of transportation networks as more companies have adopted just-in-time techniques. Despite recent demand growth and corresponding price increases, the long-term push by corporate customers for tighter supply chains and cost reductions has reduced the returns on investment to infrastructure providers below economic levels, making additional investment in infrastructure unjustifiable in many cases. Thus, surging demand cannot easily be accommodated, because the infrastructure investments that should have been made over the course of many years are lagging. For some companies, the delivery crunch has been an annoyance that needs to be managed more closely than before. Many railroad customers, for example, have had to manage their supply chains more tightly as the railroads increasingly move to scheduled timetables instead of the more flexible scheduling that had been common in the past. For other firms, these disruptions present a more serious problem. Most affected are consumer products manufacturers and retailers that rely on transportation to meet demand associated with major sales periods, such as toys at Christmas. While transportation costs as a percentage of total end consumer costs for expensive items such as electronics and high-end fashions are small, the disruption in schedules and delays wreak havoc with inventory carrying costs and delivery planning. Businesses based on marginally priced transportation are also at risk, especially those that move low-value commodities and now have seen unprecedented rate increases after decades of reductions. For low-value commodities such as scrap metal, these increases can cause wrenching changes in sourcing and supply chains. Mark Kadar is a director and Manny Hontoria is a principal of Mercer Management Consulting. They are based in Boston and can be reached at mark.kadar@mercermc.com and manny.hontoria@mercermc.com. Delivery Jam 75

2 Has the delivery system reached gridlock, impairing trade for years to come? How will supply chains cope with the projected increase in volumes? Will transport prices rise to a point where some of the major globalization trends of the past few years could halt or start to reverse? Despite real concerns about the long-term capacity crunch, we believe it is unlikely that these extreme scenarios will occur. However, transportation systems do face huge challenges. Before projecting what is likely to happen, it s instructive to review developments of the past 15 years. Déjà vu in 1990 Consider how things looked in Freight providers, shippers, and their financial backers were considering the future of global trade and the consequences for infrastructure and delivery capability requirements over the next decade. Projecting a trade growth of 6% to 7% per year, it appeared that trade volumes would effectively double over the next decade. This would require major expansions in several areas: The building of container ships with an aggregate capacity of 1.6 million 20-foot equivalent units (TEUs), requiring an investment of over $2 billion per year and corresponding increases in shipyard berths to accommodate that expansion More than doubling port infrastructure globally Expanding container handling capability in the largest ports by a factor of three, requiring significant efficiency improvements and availability of land around the ports Improvement in on-carriage truck and railroad capabilities to accommodate this growth It appeared then, just as it does now, that the requirements to sustain projected trade growth might be insurmountable. Customers, providers, and financial backers were concerned about the ability of the world s transport systems to accommodate the projected growth. Indeed, the projections at that time turned out to be conservative, as the growth in demand for international transportation was stronger than anticipated. However, all of the infrastructure investments required to address that demand growth were in fact made. Transportation and distribution capacity expanded through a variety of efforts. Huge investments in marine vessels took place, fueled in part by advantageous tax regimes. Shipyards expanded and new ones were built, especially in China. Ports improved their efficiency through better land use, more sophisticated software that improved operations, the installation of faster container cranes, and denser stacking of containers. Once notorious for slow and complex work rules, ports all over the world increased their container throughput rates dramatically, so that today the most efficient port operators regularly achieve 30 to 40 lifts per hour. Additional productivity gains are becoming harder and harder to realize. In addition, cities developed entire new ports to the point where there was overcapacity in the Mediterranean and elsewhere by the end of the decade. Railroad and trucking companies, meanwhile, increased capacity by investing in new equipment and streamlining their networks. Finally, major new distribution centers, such as the Netherlands and the city of Savannah on the U.S. East Coast, were developed to improve distribution patterns. 76 Delivery Jam

3 Exhibit 1 Ports are booming 8,000 Traffic growth at ten largest U.S. ports in 2003 (000 TEUs) 7,000 6,000 5,000 4,000 3,000 2,000 1,000 Los Angeles Long Beach New York/New Jersey Oakland Tacoma Charleston Virginia Savannah Seattle Houston Source: Containerization International, Mercer analysis train velocity is declining because of capacity constraints... Big four indexed average train speed (1Q04 = 100) Miles per hour Q04 1/21/2005 1/28/05 Note: Average train speeds for BNSF, CSX, UP, and NS weighted by 2003 train-miles. Source: NITL notice for 2/4/05, Mercer analysis and trucking firms have responded quickly to the new economics by raising prices Truckload rates 11% 9 Annual change in revenue per loaded mile* *Excludes fuel surcharges for a basket of carriers. Source: Company reports, Mercer analysis Delivery Jam 77

4 The limits and options today Now the question is whether the next decade will see a similar level of growth in infrastructure investment. Most trade forecasts assume continued trade growth of 7% or more per year. If this takes place, container imports in North America, currently about 40,000 per day, would double again within 10 years to more than 80,000 per day. Despite the transport system s historical ability to absorb significant increases in volume, we may now have reached an inflection point where constraints on growth could appear. For inland transportation, especially rail, significant increases in capacity will not be possible without difficult changes in operating processes and major investments in infrastructure, which railroads have not been making to a sufficient degree. They ve focused instead on streamlining networks and improving operational efficiency. And major hub ports are increasingly reaching their space limits, while investment in alternative ports has not yet held pace. The overall supply system, including ports, railroads, and other inland infrastructure, is beginning to reach its structural limit of capacity, implying that further rounds of infrastructure investment will need to start soon. This is not a straightforward process, as it is much harder to get approval for a new terminal or to get funds for dredging than it is to order a new ship. Shipping customers and transport carriers will have to develop different ways of dealing with each other that involve less reliance on continued, ongoing efficiency improvements and cost reductions without longer-term commitments. In essence, customers must recognize that the infrastructure providers now face the need to make substantial investments that will in turn require higher shipping rates to support the necessary financing. Over the next few years, there are three things shippers can do to improve their situation: Improve logistics through better demand management and supply chain management. While progress has been made in this area, many companies still rely on fairly unsophisticated practices. Leading-edge sourcing now includes aspects such as shifting buying terms to ex-works (the seller delivers when he places the goods at the disposal of the buyer at the seller s premises) and taking control over the inland moves, and bypassing distribution centers to ship direct to the store and factory, especially during peak seasons Raise the level of interactions with carriers and logistics providers to develop stronger direct relationships and more integrated processes. Despite more public discussion of partnerships between carriers and shippers, price has remained the primary decision criterion until recently. Rethink fundamentals by developing multiple sources, alternative routings and modes, and by doing more contingency planning. For instance, more traffic from Asia has been moving all-water to the U.S. East Coast via the Panama Canal. In addition, manufacturers are increasingly thinking about moving beyond China for some sourcing needs, revisiting Latin and South America and viewing India as the next frontier. Over the long term, we recommend a greater emphasis on longer-term agreements, co-investment structures, and maybe even joint ventures between shippers and providers in order to share both risks and rewards. Examples of such steps include terminals jointly financed by port-operating companies and shipping lines, as well as jointly financed warehousing and distribution infrastructure. 78 Delivery Jam

5 A new role for governments Because of the large sums and many interests involved, governments may have to step up their role in planning and support at a regional more than national level. Government involvement is necessary to attract private investment and to help set priorities for investments which mode to invest in (e.g., port versus rail) and which projects in what order. Public-private co-investments may need to be stepped up as well. In Europe and Asia, government involvement has been central to coordinating major transportation infrastructure projects. Well-publicized examples include the Betuweroute line corridor in the Netherlands and the enormous advances in port, rail, and road infrastructure made in recent years in China. In North America and other regions, infrastructure investments have generally tended to lag demand, and it s not clear whether the political imperative will be strong enough to shift that stance. Without a shift to developing infrastructure ahead of demand requirements, we may face a difficult period over the next decade. At stake is the competitiveness of national infrastructure and local port economies, not to mention the smooth flow of world trade. Cargo will continue to move, of course. But without a new round of planning and investment, it may move more slowly and expensively. Delivery Jam 79